DEFLATION. – A phenomenon by which the volume of means of payment decreases, for various causes, in relation to the mass of goods subject to exchange.
To understand deflation in its scope and effects, it is necessary to start from the so-called equation of exchange, which essentially serves to highlight the relationship between the amount of means of payment on the one hand and the total of exchanged goods on the other, with the general level of prices. Its formulation is: the volume of money is equal to the general level of prices multiplied by the quantity of goods exchanged. It is immediately apparent that there is a direct proportionality between the level of prices and the volume of money, while there is an inverse proportionality between the level of prices and the mass of goods subject to exchange. This is evident from the transformation of the formula, whereby the general level of prices is equal to the ratio between the volume of money and the quantity of goods exchanged. Strictly speaking, therefore, a decrease in the general level of prices may derive either from a decrease in the volume of money or from an increase in the mass of goods exchanged. Except in exceptional cases (wars, earthquakes, etc.), this second factor is normally stable, varying significantly only over long periods of time. On the other hand, the amount of means of payment can undergo marked contractions, while the other factor remains unchanged; and it is generally to this phenomenon that almost all deflations hitherto verified must be attributed. Hence, it must be considered that deflation consists more in an absolute decrease in the volume of money than in its relative decrease as a result of the increase in the mass of goods. It is well to recall that one can speak of a genuine deflationary process only when it reaches an intensity sufficient to affect the level of prices with a significant decline.
While the expansion of the monetary circulation, i.e., inflation, is usually not deliberately practiced by the responsible authorities, deflation in every case represents a voluntary and conscious act. Through deflationary policy, the aim is normally to restore currencies, depreciated by inflation, to their previous value or at least to a higher value, when the more limited objective of monetary stabilization is deemed insufficient. After the war of 1914–18, several countries that had suffered severe devaluations adopted deflationary policy, among them Italy, but it was particularly Britain that pursued this experiment to its fullest extent. As some economists had warned, the results achieved, when they were achieved, entailed heavy sacrifices and provoked deep adjustment crises. Indeed, since entrepreneurs usually bear most production costs before the sale of finished goods and are often bound by long-term contracts, a decline in prices does not correspond to an immediate decrease in costs, and thus business activity results in losses. This leads, on the one hand, to a slowdown that may reach the point of paralysis in the productive rhythm, and on the other, to the formation or intensification of unemployment across every category of production workers. It was nevertheless argued at the time that deflation was necessary to redress the injustices that had occurred in the distribution of wealth and income following monetary devaluations. It is well known that inflation harms creditors and benefits debtors, and while it advantages the active economic categories of entrepreneurs and merchants, it compromises the situation of those who enjoy fixed incomes. Apart from the lamented drawbacks, it was found that deflation is counterproductive in this respect, in fact consolidating the advantages gained through inflation, while usually, especially through unemployment, aggravating the harm suffered by those classes for whose benefit greater justice was invoked.
Recourse to deflationary measures is instead legitimate and useful when it is intended to remedy, through a reduction in the level of domestic prices, a disequilibrium that has arisen in relation to the trend of international prices.